Wednesday, June 30, 2010

We've had too much financial "innovation" and not enough institutional innovation.

The key context in any discussion of innovation is the returns generated. If they are marginal, then the innovation is of limited value.

In the realm of financial "innovation," the returns were phenomenal for a handful of Wall Street players selling mortgage-backed securities and for a much larger group of unscrupulous mortgage brokers who "gamed the system" and foisted high-risk or fraudulent mortgages onto secondary markets as if they were truly qualified and low-risk.

For the nation at large, the returns on the past decade's financial "innovations" of exponentially increasing leverage and debt, fraud, mispricing of risk and collusion have been catastrophic.

On the scientific front, many innovations in pharmaceuticals have been marginal, once side-effects and often-poor results are factored in.

On the institutional level, there has been little to no innovation, only more status-quo regulation which has generated dubious returns in terms of transparency or improvements and quite possibly negative returns when the costs of compliance are factored in.

So the key to truly productive innovation is that the return is substantial and scalable and the risks are properly assessed and priced.

In many cases, the innovation's returns/benefits are oversold and over-promised, while the inherent risks are misrepresented, glossed over and discounted.

Thus we have "safe" medications which are suddenly discovered to have serious side-effects, and "safe" 13,000-foot deep oil wells which blow out one mile beneath the surface of the sea.

Risk can be mis-assessed and also mispriced. The risks of Fannie Mae imploding were actually quite high, but the risk was mis-assessed and mispriced. Investors who believed the status-quo assessment of risk were wiped out.

This context plays an important function in technical innovations, not just in financial or institutional innovations.

A photovoltaic panel will not blow up, but a solar heat collector which heats water (or other substance) to high temperatures could well blow a valve. A geothermal exchange system will not blow up, but a geothermal well might trigger earthquakes and could release steam. These risks--the escape of steam and the triggering of small earthquakes--can be assessed, mitigated and balanced against the benefits, but the Gulf oil blowout is stark evidence that risk management and mitigation of inherently risky systems does not render them without risk.

Inherently low-risk systems do not need elaborate counter-measures and redundancies.

The First Big Question of this century is how do we replace the cheap, high-density energy of petroleum and natural gas. If oil were really as abundant as many seem to think, why does it require dropping a mile-long pipe in deep water and then drilling a 13,000-foot deep well to extract it?

Given the horrendous expense and the inherent risks, that doesn't seem like a good investment if cheaper/easier-to-get oil was as abundant as some seem to believe.

The solar radiation which bathes the planet every day is substantial. Some of this is captured by plants in photosynthesis, some is captured in heat, and a tiny sliver is captured via electronics or heat collectors and turned into electricity.

The rap against alternative energy is that it is fundamentally low-density. In other words, it doesn't come pre-packaged like petroleum in a transportable, high-energy density form. Wind, solar, tidal energy, etc. are diffuse and must be collected and condensed into higher-density energy which can be stored or distributed.

If we consider the basic physics--the abundance of solar energy and the need for high-density storage and transport--then we can conclude that innovative storage technolgies will offer high returns. Many observers believe hydrogen is the obvious choice for storing solar energy (to be used in fuel cells)--whether it is solar energy converted into algae, hot water or directly into electricity.

Others note that compressed hydrogen has potentially explosive risk factors, and in terms of vehicle transport then batteries might offer a lower risk source of concentrated power. Large-scale storage of energy would also benefit from scalable innovations.

If the energy source is essentially free and the collection process essentially low-risk, then the calculus of risk and return is quite different from an inherently dangerous energy collection/storage technology.

The Second Big Question of this century is how can we do more with the energy we do collect/extract. Take a vehicle which gets 10 miles per gallon of gasoline. Now to drive that vehicle 400 miles, we need to extract oil and then refine it into 40 gallons of gasoline.

Alternatively, we extract 40 miles per gallon from the vehicle and then we find/refine 10 gallons of gasoline. The result--400 miles--is the same in each case.

Once oil becomes scarce and/or very costly, then the truly high-return innovation would be to make a vehicle which gets 200 miles per gallon of gasoline or other liquid fuels. Then only two gallons of fuel would be needed to drive 400 miles.

The model of development of energy since the start of the Industrial Revolution has been to go find more cheap sources as energy demand rose. That model is running into a variety of limits, physical and political. Therefore extracting more work from the energy we do have is the preferable model.

The "market" is not always a productive arbiter of such value. The 5% of total U.S.-generated electricity squandered daily on zombie and stand-by electronics will never be addressed by the "market" because the consumer will never demand such a modest change nor will manufacturers gain any competitive advantage from the modest extra cost of manufacture.

Only the State can impose such common-sense practices on a market which cannot recognize or register a 5% loss of the nation's electricity because the market is individuals who will not respond to 5% of their electricity being wasted.

The Central State imposed common-sense conservation regulations on home appliances after the 1973 Oil Crisis and energy consumption actually declined as these modest measures took effect. Nobody "suffered" because their refrigerator required less electricity.

The broad outlines of high-return innovations in technology are clear; the innovations we need in institutions are less clear but no less needed.

To take but one example: is there truly no other way to educate people in the skillsets which will be valuable going forward (creativity, ability to learn on one's own, ability to work in teams, flexibility, etc.) other than a horrendously costly university? Is there truly no other way to run a university except to charge students $30,000 a year or a total of $120,000 for four years?

Or did this institutional cost arise because "free money" was available from student loans? If government-funded and pushed student loans were ended tomorrow (which would be my recommendation), then the hundreds of colleges and universities which have grown dependent on this model of finance and education would face a stark choice: either close down or come up with an innovative way to offer education for (say) $5,000 a year.

The same institutional shock and forced innovation will occur when (not if) Medicare and Medicaid implode and the endless supply of "free money" from the Federal government ends. A pharmaceutical company can offer medications at $10,000 a dose all it wants but there will be few buyers. Either that firm will go bankrupt from lack of sales or the price of the med will magically fall to what people can actually afford.

The fact that so many people automatically claim that such institutional innovation is "impossible" is proof of our shrunken imagination and limited conceptual understanding of innovation.

We understand technical innovations easily and expect them; but institutional innovations which offer just as high returns, if not higher, than new technologies, are verboten, impossible, beyond imagination.

Here is one example. How much money would it take to close a street to cars and trucks? Almost nothing--a few concrete barriers and signs. This "innovation" would be making travel by bicycle cheaper, easier, safer and in many cases faster than travel by car.

But we find this sort of innovation uninspiring and tepid; if there were a monorail being proposed, or flying bicycles, that would pique our enthusiasm and interest. But simply making a cheap, convenient form of transport more readily available and safer offers no zing. And of course, the inertia of the status quo is immense; though there are 99 other streets still open to them, drivers would undoubtedly protest the closure of a single street--not because it was truly essential but simply because it would be perceived as a "needless limit."

If we are truly after "faster, better, cheaper and lower energy consumption" then we have to look at sclerotic, bloated, inefficient institutions and social habits which haven't changed substantially since the 1950s.

Is there really no other way for an accredited university to educate people without the overhead and costs which make $30,000 a year the "minimum cost"? What if student loans were no longer enabled, and people had to save up and pay cash? Isn't it possible that new institutional forms would arise to meet the demand for education which isn't funded by loans?

What if low-risk, long-lasting collector and storage technologies got the same enormous tax breaks that deepwater oil drilling receives? What innovations might arise from that simple institutional rebalancing of perceptions and priorities?

Yes, we need innovations--not just consumer gizmos, but technologies which offer high returns and low risks on energy production and conservation. And just as importantly, we need to face up to the inherent risks of financial "innovations" and to the stupendous need and opportunity for institutional innovations.

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